Markets’ Tariff Response May Bring Both Sides to Table

Markets’ Tariff Response May Bring Both Sides to Table

“We remain optimistic a deal will be struck,” says CIO Larry Adam.

While optimism had been growing that the U.S. and China were nearing the final stages of a trade deal, market uncertainty moved sharply higher following President Donald Trump’s Sunday tweet that threatened to raise tariffs from the existing 10% to 25% on $200 billion worth of Chinese goods and potentially add tariffs to an additional $325 billion dollars of Chinese imports at 25%. In total, that amounts to the potential of $575 billion in Chinese imports being taxed at 25% (~$144 billion or 0.7% of U.S. GDP). As a result, the potential parameters of what constitutes a “deal” have expanded, with increased downside risk.

A reduction of overall tariffs could lead to upside pressure in the equity market and an increase in tariffs could lead to further downside pressure. The timing and enforcement of these tariffs will similarly play a role in the market response.

Will a Deal Be Struck?

We remain optimistic a deal will be struck. We disagree with many market pundits that believe better economic conditions in both the U.S. and China have emboldened each side to be more aggressive in negotiating. To the contrary, the current “indefinite” postponement of the tariffs and apparent progress in the trade discussions has helped sentiment and led to better economic and equity market performance. Increased tariffs and trade war rhetoric could cause that economic momentum to be short-lived, with both sides incurring at least short-term negative repercussions. Thus, a negative response to increased tariffs could force both sides back to the negotiating table.

With President Trump having such favorable polling on his handling of the U.S. economy (56% approval rate), it is unlikely that he would want to jeopardize the momentum of the economy and dampen his prospects for re-election. However, no one knows what the timing could be or what the framework of a deal would look like. Therein lies the “cliffhanger” for the market.

What Could a Deal Look Like?

Our instincts tell us that a deal will ultimately be reached. The new threat of an additional $325 billion dollars is unlikely. It would be difficult to implement as that would essentially include all Chinese imports, with no exceptions. If the current rate on the $200 billion goes to 25% (from 10%), it will likely be for a limited amount of time as both sides continue to talk. In the end, it is our belief that President Trump wants to engineer a deal that ultimately lowers tariffs from current levels to show he has effectively made a deal. Not all tariffs will be removed as the President needs an enforcement mechanism in place and is likely to use them as a tool to reference in his re-election bid. A deal should provide a catalyst to push global equities higher, especially emerging markets (EM) equities, and would be supportive of more cyclical and internationally-exposed sectors such as industrials and info tech.

What Is the Downside Risk?

If both sides walk away from the table and the 25% tariff (from 10%) goes into effect, it will likely lead to further downside for global equities, with emerging market equities, especially China, getting hurt the most. However, while we see a modest pullback, we do not expect a redux of the ~20% decline experienced in late 2018 for U.S. equities, as a number of key risks have been removed from the market since then. First, interest rates (10-year Treasury yield) have declined significantly and are down ~75 basis points from the September high. Second, the Fed has moved to the sideline as the market is now pricing in a 66% chance of a rate cut in 2019 relative to the expected one to two 2019 interest rate hikes expected last September. Lastly, U.S. recessionary concerns have abated as fundamentals (employment, retail sales, earnings growth) remain solid and have arguably improved over recent months.

All expressions of opinion reflect the judgment of Raymond James & Associates, Inc. and are subject to change. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Past performance is not indicative of future results. No investment strategy can guarantee success. There is no assurance any of the trends mentioned will continue or that any of the forecasts mentioned will occur. Economic and market conditions are subject to change. Investing involves risks including the possible loss of capital. Technical Analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. Further information regarding these investments is available from your financial advisor. Material is provided for informational purposes only and does not constitute a recommendation. Sector investments are companies engaged in business related to a specific sector. They are subject to fierce competition and their products and services may be subject to rapid obsolescence. There are additional risks associated with investing in an individual sector, including limited diversification. International investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. Investing in emerging markets can be riskier than investing in well-established foreign markets. Investing involves risk and investors may incur a profit or a loss. U.S. Treasury securities are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value.

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